Institutions Dial Back

After a major buying binge in commercial real estate in recent years, pension funds and endowments plan to curb investment by 22% in 2007, according to a newly released survey. What's more, institutions increasingly are opting to buy properties in need of repositioning or renovation as part of a value-added investment approach to higher returns.

The survey of 109 respondents, primarily senior investment officers for public and corporate pension funds, was conducted by Institutional Real Estate Inc., a publishing and consulting firm based in San Ramon, Calif. , and Kingsley Associates, a San Francisco-based research company.

Plan sponsors expect to invest a combined $46 billion in commercial real estate this year, down from $59 billion in 2006. Meanwhile, respondents' target allocation for real estate in proportion to their total asset holdings is 8.7%, up from 7.9% a year ago.

Specifically, survey respondents plan to spend $15.8 billion, or 34% of new capital, on value-added properties that require some improvements compared with $11.5 billion, or 24.8% of new capital, dedicated to core properties.

“While real estate is still very attractive, investors are reducing their capital commitment largely because their holdings are much closer to their target allocations,” says Jim Woidat, a Kingsley principal in San Francisco. “Real estate continues to outperform expectations.”

Respondents upped their return expectations to 9.3% from 8.1% a year ago. Actual returns in 2006 were 11.9%. “Last year, we had a combination of better demand for space due to an improved economy, and more capital invested, which drove returns beyond initial expectations,” says Russell Appel, president of The Praedium Group, a New York pension fund advisor specializing in value-added strategies. “This year will be another strong year.”

Since investing $28 billion in real estate in 2002, plan sponsors had consistently raised the total dollar amount each year before topping out at $59 billion last year.

The growth of investment is slowing, acknowledges William Maher, director of North America Investment Strategy for LaSalle Investment Managers, a Chicago pension fund advisor. “This is the first time in a long time that they are close to their target allocations.”

New money is still flowing into the market. Pension plans, such as those in Arizona, New Jersey and Texas, have close to zero real estate holdings and are investing billions to ramp up their programs, Maher says. Many retirement funds are jumping into the market as a result of new laws allowing such investments. LaSalle also is pointing its clients toward value-added strategies. “If you buy a core building without leverage, you would expect returns of 7% to 8%,” Maher says.

Core properties currently comprise 51.6% of institutional real estate portfolios. Plan sponsors plan to reduce their core target allocation to 46.8% this year, Kingsley's Woidat says. At the same time, value-added holdings are expected to rise from 17.6% to 19.6%.

Another key finding in the study is the anticipated increase in competition for fund managers, says Woidat. “We are beginning to see greater reliance on existing relationships with investment partners. Investment professionals looking to raise capital are expected to have more competition. There will be a greater need for differentiation from their peers.”